Last editedOct 20222 min read
Software capitalisation is the practice of treating software as a business asset rather than a business expense. This allows its purchase/development costs to be amortised over its useful life. Software capitalisation is a complex topic, so it’s best to discuss specific questions with an accountant. Here is a simple guide to the key points.
When you can capitalise software costs
You can only capitalise software costs if you have funded the development of the software. Capitalising software costs is therefore only possible in one of three situations, where you have:
had a third party develop software for your own internal use
developed software in-house for your own internal use
developed software to sell/licence to other people.
You cannot capitalise off-the-shelf software purchases because you have not directly funded their development. These would be classed as expenses, normally operating expenses. They may be tax deductible.
Furthermore, the software must be a fixed asset. This means it needs to have an expected useful life of more than one year. If its expected useful life is less than this, amortisation becomes irrelevant. By contrast, the longer the software is expected to be used, the more advantageous it is to amortise its costs.
Likewise, the cost of the software has to be high enough to be worthwhile amortising. This is where business management has to exercise judgement, and it is very important that this judgement is both reasonable and consistent.
Management should agree on a cut-off point above which costs will be capitalised if possible, and should also record the reasoning behind their decision. The chosen figure should be reassessed periodically, typically once a year but it could be more often if circumstances warrant it (e.g. during high inflation).
How to capitalise software costs
If you have had a third party develop software for you, capitalising software costs is fairly straightforward. You have been charged a specific price to buy it from them. Therefore simply amortise this cost over the expected useful life of the software. If you have developed the software yourself, value its development costs yourself.
In addition to the costs of the actual development team (in-house or freelance), include fees for third-party consultants, testing fees and any overhead costs directly or indirectly linked with the project.
Capitalising software costs for in-house software
You can only capitalise software costs for the actual development stage of the project. That means the stage during which the software is coded, installed and tested. You cannot capitalise the costs of the planning stage or after the software is signed off as being in live use. Any costs incurred once the software is live are considered operational costs.
Capitalising software costs for software intended for resale
You can only capitalise software costs once the software has reached the stage where it is ready for customer testing. All costs incurred in scoping, coding, installing and testing the product internally must be expensed. Once the software is confirmed as being ready for sale, stop capitalising costs and record them as incurred expenses.
Software capitalisation and tax
Capitalising software costs means that the company’s income is reduced by a small amount over two or more years. Expensing software costs means that the entire cost is absorbed in one year. If tax bands remain the same, the net effect is zero. If they change, the business may be placed at a disadvantage.
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